iCAD (ICAD) announced financial results for the third quarter ending September 30, 2011 on October 27th. Similar to the prior quarter, revenue again came in well ahead of our estimate. However, unlike Q2 where a slightly softer than anticipated gross margin and higher than modeled operating expenses more than offset the beat on the top-line (resulting in lower than estimated EPS), Q3's results were better than our numbers in all three categories (i.e. - revenue, gross margin and operating expenses). The result was a big beat on EPS (adjusted for one-time items) in Q3.
Revenue of $8.05MM was up 44% y-o-y and 15% better than our $7.0MM estimate, the difference mostly a result of Digital & MRI CAD revenue coming in over $600k ahead of our number.
- Products revenue: $5.76MM actual vs. $4.9MM estimate
- Digital & MRI CAD revenue was $3.79MM, up 15% y-o-y and significantly better than our $3.18MM estimate (implying -4.0% growth). MRI CAD sales continue to be relatively strong in the U.S. but remain soft overseas. Management noted on the call that mammography CAD sales benefitted from a strong introduction of their SecondLook multi-vendor product. iCAD does not break out sales of MRI CAD versus that for mammography, although management has indicated in the past that the majority of revenue from this category comes from mammography. Growth in iCAD's mammography CAD sales have historically closely tracked that of new digital mammography systems (as reported by FDA's MQSA data) - which management noted continued to be the case through the first nine months of 2011.
- Film-based revenue was $616k, down 18% but better than our $500k estimate
- Electronic brachytherapy (Axxent) devices revenue came in at $1,347k, ahead of our $1,200k estimate. Management noted that they sold several systems during the quarter including overseas. As we have indicated in the past, the assignment of CPT codes should be a further catalyst to increasing the placement rate. The American Medical Association assigned CPT codes for IORT in early October. Reimbursement payment amounts are expected to be assigned any day now.
- Services / supplies revenue: Came in at $2.3MM ($441k Axxent-related, $1,857k CAD-related), up 51% y-o-y and ahead of our $2.1MM ($576k Axxent-related, $1,576k CAD-related) estimate
Q3 EPS on a GAAP basis was ($0.46) but, stripping out one-time items, came in at ($0.04), compared to our ($0.08) estimate. The $0.04 positive difference between actual adjusted EPS and our estimate was split between better than modeled revenue ($0.016), gross margin ($0.005), and significantly lower operating expenses ($0.023).
It is worth noting that gross margin, at 73.1% in Q3, was particularly strong (GM was 69.9% in Q1 and 67.8% in Q2) and significantly wider than where we had it modeled (69.8%). We have since increased our GM estimate for Q4 from 69.4% to 71.7% - which could still prove conservative as this implies full-year GM of 70.8%, slightly below the low-end of management's GM guidance of 71% - 73%.
We have also adjusted our future operating expense estimates as a result of iCAD trimming expenses quicker and deeper than we had earlier anticipated. Operating expenses were almost $1.5MM less than where we had them modeled in Q3 and fell about $2.8MM (excluding a severance charge) from Q2 - which is a testament to management delivering on their previously announced cost-cutting initiatives.
The non-recurring, non-cash items in Q3 included a $26.8MM charge for goodwill impairment (related to the drop in iCAD's stock price during Q3) and a $3.8MM gain reversing the liability iCAD had been carrying as an estimate for potential earn-outs payable to Xoft which is contingent on iCAD hitting minimum pre-determined sales of Axxent and related consumables.
Management reiterated revenue guidance of $30MM - $32MM for 2011. Gross margin guidance is 71% - 73%.
Prior to Q3 results we were modeling 2011 revenue of $29.7MM. We now look for revenue of $30.5MM. We moved our 2011 non-GAAP (adjusted for one-time items) EPS estimate from ($0.34) prior to Q3 results to our current ($0.28). Our 2011 GAAP EPS estimate moved from ($0.33) to ($0.68).
We have also made some slight adjustments to our later years EPS estimates, mostly reflecting our updated view on operating expenses (which we have moderately trimmed) and gross margins (which have increased very slightly).
We continue to value iCAD at $1.30/share and are maintaining our Outperform rating on the stock.
SecondLook Premier: "Reader study" completed during Q3. Management expects FDA filing by the middle of November and hopes to have the product in the U.S. market by late in the first half of 2012 - this is commensurate with our previous expectations. SecondLook is already available in Europe, Canada and China.
CPT I Code: AMA assigned CPT codes for Intraoperative Radiation Therapy in early October. The codes, 77424 and 77469, will be active January 1, 2012. Reimbursement amounts under these codes are expected to be announced by November 1st. If all goes well, the level of reimbursement (i.e. - relative value) will incentivize (or at least does not dis-incentivize) radiation oncologists to use IORT instead of EBRT or APBI for those patients where it is appropriate. Assuming that turns out to be the case, this should be a significant catalyst to increasing demand for Axxent.
Digital & MRI CAD
Digital & MRI CAD accounted for 82% of product revenue and 63% of total revenue in 2010. While iCAD does not disclose the percentage of Digital & MRI CAD revenue that comes from digital CAD (i.e. - mammography CAD), management has indicated that it represents the vast majority. Therefore, especially in the near-term, sales of iCAD's mammography CAD products will have the greatest influence on growth in Digital & MRI CAD revenue. Sales in international markets, which can be somewhat choppy, accounted for approximately 16% of total revenue in 2010.
Despite film-based systems still accounting ~ 22% of all mammography instruments in the U.S., we expect Digital & MRI CAD revenue to continue to struggle in the near-term as a result of the continued slowing pace of film-to-digital conversions. Mammography CAD sales in iCAD's international markets was also soft in the first nine months of 2011 despite the roll-out of SecondLook Premier in Canada and Europe during Q1. Economic softness hampered international mammography CAD sales which is expected to continue through at least the end of 2011. Management recently indicated that sales of MRI CAD has been very strong as a result of new product launches in late 2010.
While MRI CAD should continue to show strength through the remainder of 2011 from the roll-out of new OEM agreements and the continued benefit of recent product enhancements, due to the relatively small contribution to overall revenue, growth in this segment will likely not be enough to offset declining mammography CAD sales.
We model a rebound in Digital & MRI CAD sales growth beginning in 2012 due to a combination of factors. The declassification of digital mammography from PMA to 510(k) that happened in late 2010 has sparked a resurgence in activity from several OEM's, a number of which are in various stages of bringing new digital mammography systems to market.
The major catalyst to Digital / MRI growth in 2012 should be the launch of SecondLook in the U.S. - if all goes well a 510(k) filing will happen later this year and the product will hit the U.S. market by mid-2012. And finally, CAD for CTC, breast MRI and prostate MRI could all see an uptick in demand. CTC (VeraLook) should benefit from the recent agreement with Vital Images and new potential deals with GE and Philips materializing in 2012. Re-evaluation of the ACRIN study should be completed and published and potentially lead to eventual Medicare reimbursement - if that happens iCAD's CTC CAD sales could ramp quickly. Prostate MRI (VividLook), while still struggling to gain acceptance despite proven benefits against PSA, may experience slow but steady growth.
iCAD has seen some success in terms of sales of VividLook through education about the benefits of prostate MRI CAD which should continue to be the case in 2012. Breast MRI (SpectraLook), which remains a significant growth category in Europe, could reverse the recent slide in international sales, especially with strengthening in world economies.
Film-based accounted for 18% of product revenue and 14% of total revenue in 2010. We model film-based sales to continue to decline going forward as a direct result of the slowing conversion rate of film to digital mammography.
Xoft revenue was approximately $5.5MM in 2010 (prior to iCAD's acquisition). Xoft product revenue, which includes sales of the Axxent controller, in Q1 2011, the first full quarter under iCAD, was $960k. Xoft service and supplies revenue, which includes sales of the x-ray source, disposables and extended warranties, was $360k. iCAD/Xoft announced the recall of the FlexiShield in early February 2011. The recall softened Axxent sales in Q2, which fell to $760k (plus $407k in related services and supplies) as customers had been hesitant to buy the system until a replacement shield is available. The new shield received FDA clearance in late July and helped jump-start Axxent sales - pushing revenue to $1,347k in Q3 (plus $441k in related services and supplies).
We model total (Axxent controller and supplies/services) Xoft sales of $7.5MM in 2011. Going into 2012 we think Xoft sales could begin to show a significantly greater rate of growth, predicated on the assumption that CPT I code reimbursement amount is favorable. This also assumes that there are no significant lingering hangovers from the shield recall. Our Xoft-related revenue forecasts assume Axxent's penetration of the brachytherapy-appropriate breast cancer market (currently ~ 110k annual procedures) is approximately 4% by year-end 2012, 10% in 2013 and 15% in 2014, the market grows at 2% per year and 3 procedures per unit per week. Our model also includes only marginal revenue contribution from Xoft for indications other than breast cancer (i.e. - skin, endometrial, veterinary, etc.) as we currently view these as more ancillary applications.
Revenue and EPS Estimates
Management's revenue guidance as of 5/3/2011 for 2011 was $32MM - $35MM. This was revised lower from $34MM - $38MM following the recall of FlexiShield. Management again revised guidance lower with the announcement of Q2 earnings to $30MM - $32MM - this guidance was affirmed with the release of Q3 earnings.
Prior to Q3 results we were modeling 2011 revenue of $29.7MM. We now look for revenue of $30.6MM. We moved our 2011 non-GAAP (adjusted for one-time items) EPS estimate from ($0.34) prior to Q3 results to our current ($0.28). Our 2011 GAAP EPS estimate moved from ($0.33) to ($0.68).
We have also made some slight adjustments to our later years EPS estimates, mostly reflecting our updated view on operating expenses (which we have moderately trimmed) and gross margins (which have increased very slightly). We look for revenue to grow to $38.4MM in 2012 and $83.5MM in 2014. We now model EPS of ($0.18) in 2012 and approximately break-even EPS in 2014.
VALUATION / RECOMMENDATION
As we model iCAD to post negative income and EPS through 2014, valuation using a P/E multiple is not appropriate. Instead we value iCAD using competitor price/sales (P/S) and enterprise value/sales (EV/S) multiples. Using analyst's revenue estimates for the years 2011 and 2012, we calculated P/S and EV/S ratios from imaging (HOLX, MRGE) as well as surgical (VAR, ARAY, ISR) companies. The five companies currently trade at an average P/S-2011 of 2.6x, P/S-2012 of 1.9x, EV/S-2011 of 2.7x and EV/S-2012 of 2.1x.
Our 2011 and 2012 revenue estimates for iCAD are $30.5MM and $38.5MM. On the basis of the comp ratios above, iCAD's stock is valued at between $1.37 (using P/S-2011) and $1.75 (using EV/S-2012). While we would normally feel it appropriate to just use the average of the two (~ $1.60), as noted earlier in the report, we believe the potential liability related to FlexiShield lawsuits introduces material risk and this should be factored into the valuation. To account for this risk we think it is appropriate to handicap the valuation by 20%, which values iCAD at approximately $1.30/share. If future developments suggest a favorable outcome to iCAD related to FlexiShield liability is likely, we think it may be appropriate to reduce or eliminate this valuation discount.
As it is now we value iCAD at $1.30/share. The stock, trading at around $0.71, remains significantly undervalued in our opinion. As such, we are maintaining our Outperform rating.